Liquidity Trap or Credit Deadlock

In earlier posts in my series about Hawtrey and Keynes, I’ve mentioned the close connection between Hawtrey’s concept of a “credit deadlock” and the better-known Keynesian concept of a “liquidity trap,” a term actually coined by J. R. Hicks in his classic paper summarizing the Keynesian system by way of the IS-LM model. As I’ve previously noted, the two concepts, though similar, are not identical, a characteristic of much of their work on money and business cycles. Their ideas, often very similar, almost always differ in some important way, often leading to sharply different policy implications. Keynes recognized the similarities in their thinking, acknowledging his intellectual debt to Hawtrey several times, but, on occasion, Keynes could not contain his frustration and exasperation with what he felt was Hawtrey’s obstinate refusal to see what he was driving at.

In this post, commenter GDF asked me about the credit deadlock and the liquidity trap:

Would you mind explaining your thoughts apropos of differences between Hawtrey’s credit deadlock theory and Keynes’ liquidity trap. It seems to me that modern liquidity trapists like Krugman, Woodford etc. have more in common with Hawtrey than Keynes in the sense that they deal with low money demand elasticity w.r.t. the short rate rather than high money demand elasticity w.r.t. the long rate.

To which I answered:

My view is that credit deadlock refers to a situation of extreme entrepreneurial pessimism, which I would associate with negative real rates of interest. Keynes’s liquidity trap occurs at positive real rates of interest (not the zero lower bound) because bear bond speculators will not allow the long-term rate to fall below some lower threshold because of the risk of suffering a capital loss on long-term bonds once the interest rate rises. Hawtrey did not think much of this argument.

Subsequently in this post, commenter Rob Rawlings suggested that I write about the credit deadlock and provided a link to a draft of a paper by Roger Sandilands, “Hawtreyan ‘Credit Deadlock’ or Keynesian ‘Liquidity Trap’? Lessons for Japan from the Great Depression” (eventually published as the final chapter in the volumeDavid Laidler’s Contributions to Economics, edited by Robert Leeson, an outstanding collection of papers celebrating one of the greatest economists of our time). In our recent exchange of emails about Hawtrey, Laidler also drew my attention to Sandilands’s paper.

Sandilands’s paper covers an extremely wide range of topics in both the history of economics (mainly about Hawtrey and especially the largely forgotten Laughlin Currie), the history of the Great Depression, and the chronic Japanese deflation and slowdown since the early 1990s. But for this post, the relevant point from Sandilands’s paper is the lengthy quotation with which he concludes from Laidler’s paper, “Woodford and Wicksell on Interest and Prices: The Place of the Pure Credit Economy in the Theory of Monetary Policy.”

To begin with, a “liquidity trap” is a state of affairs in which the demnd for money becomes perfectly elastic with respect to a long rate of interest at some low positive level of the latter. Until the policy of “quantitative easing” was begun in 2001, the ratio of the Japanese money stock to national income, whether money was measured by the base, M1, or any broader aggregate, rose slowly at best, and it was short, not long, rates of interest that were essentially zero. Given these facts, it is hard to see what the empirical basis for the diagnosis of a liquidity trap could have been. On the other hand, and again before 2001, the empirical evidence gave no reason to reject the hypothesis that a quite separate and distinct phenomenon was at work, namely a Hawtreyan “credit deadlock”. Here the problem is not a high elasticity of the economy’s demand for money with respect to the long rate of interest, but a low elasticity of its demand for bank credit with respect to the short rate, which inhibits the borrowing that is a necessary prerequisite for money creation. The solution to a credit deadlock, as Hawtrey pointed out, is vigorous open market operations to bring about increases in the monetary base, and therefore the supply of chequable deposits, that mere manipulation of short term interest rates is usually sufficient to accomplish in less depressed times.

Now the conditions for a liquidity trap might indeed have existed in Japan in the 1990s. Until the credit deadlock affecting its monetary system was broken by quantitative easing in 2001 . . . it was impossible to know this. As it has happened, however, the subsequent vigorous up-turn of the Japanese economy that began in 2002 and is still proceeding is beginning to suggest that there was no liquidity trap at work in that economy. If further evidence bears out this conclusion, a serious policy error was made in the 1990s, and that error was based on a theory of monetary policy that treats the short interest rate as the central bank’s only tool, and characterizes the transmission mechanism as working solely through the influence of interest rates on aggregate demand.

That theory provided no means for Japanese policy makers to distinguish between a liquidity trap, which is a possible feature of the demand for money function, and a credit deadlock which is a characteristic of the money supply process, or for them to entertain the possibility that variations in the money supply might affect aggregate demand by channels over and above any effect on market rates of interest. It was therefore a dangerously defective guide to the conduct of monetary policy in Japan, as it is in any depressed economy.

Laidler is making two important points in this quotation. First, he is distinguishing, a bit more fully than I did in my reply above to GDF, between a credit deadlock and a liquidity trap. The liquidity trap is a property of the demand for money, premised on an empirical hypothesis of Keynes about the existence of bear speculators (afraid of taking capital losses once the long-term rate rises to its normal level) willing to hold unlimited amounts of money rather than long-term bonds, once long-term rates approach some low, but positive, level. But under Keynes’s analysis, there would be no reason why the banking system would not supply the amount of money demanded by bear speculators. In Hawtrey’s credit deadlock, however, the problem is not that the demand to hold money becomes perfectly elastic when the long-term rate reaches some low level, but that, because entrepreneurial expectations are so pessimistic, banks cannot find borrowers to lend to, even if short-term rates fall to zero. Keynes and Hawtrey were positing different causal mechanisms, Keynes focusing on the demand to hold money, Hawtrey on the supply of bank money. (I would note parenthetically that Laidler is leaving out an important distinction between the zero rate at which the central bank is lending to banks and the positive rate — sufficient to cover intermediation costs – at which banks will lend to their customers. The lack of borrowing at the zero lower bound is at least partly a reflection of a disintermediation process that occurs when there is insufficient loan demand to make intermediation by commercial banks profitable.)

Laidler’s second point is an empirical judgment about the Japanese experience in the 1990s and early 2000s. He argues that the relative success of quantitative easing in Japan in the early 2000s shows that Japan was suffering not from a liquidity trap, but from a credit deadlock. That quantitative easing succeeded in Japan after years of stagnation and slow monetary growth suggests to Laidler that the problem in the 1990s was not a liquidity trap, but a credit deadlock. If there was a liquidity trap, why did the unlimited demand to hold cash on the part of bear speculators not elicit a huge increase in the Japanese money supply? In fact, the Japanese money supply increased only modestly in the 1990s. The Japanese recovery in the early 200s coincided with a rapid increase in the money supply in response to open-market purchases by the Bank of Japan. Quantitative easing worked not through a reduction of interest rates, but through the portfolio effects of increasing the quantity of cash balances in the economy, causing an increase in spending as a way of reducing unwanted cash balances.

How, then, on Laidler’s account, can we explain the feebleness of the US recovery from the 2007-09 downturn, notwithstanding the massive increase in the US monetary base? One possible answer, of course, is that the stimulative effects of increasing the monetary base have been sterilized by the Fed’s policy of paying interest on reserves. The other answer is that increasing the monetary base in a state of credit deadlock can stimulate a recovery only by changing expectations. However, long-term expectations, as reflected in the long-term real interest rates implicit in TIPS spreads, seem to have become more pessimistic since quantitative easing began in 2009. In this context, a passage, quoted by Sandilands, from the 1950 edition of Hawtrey’s Currency and Credit seems highly relevant.

If the banks fail to stimulate short-term borrowing, they can create credit by themselves buying securities in the investment market. The market will seek to use the resources thus placed in it, and it will become more favourable to new flotations and sales of securities. But even so and expansion of the flow of money is not ensured. If the money created is to move and to swell the consumers’ income, the favourable market must evoke additional capital outlay. That is likely to take time and conceivably capital outlay may fail to respond. A deficiency of demand for consumable goods reacts on capital outlay, for when the existing capacity of industries is underemployed, there is little demand for capital outlay to extend capacity. . .

The deadlock then is complete, and, unless it is to continue unbroken till some fortuitous circumstance restarts activity, recourse must be had to directly inflationary expedients, such as government expenditures far in excess of revenue, or a deliberate depreciation of the foreign exchange value of the money unit.

” But under Keynes’s analysis, there would be no reason why the banking system would not supply the amount of money demanded by bear speculators”

This is partially true, and that’s why the liquidity trap that Keynes had set out in the Treatise was as yet incomplete. Keynes then went on to complete the argument by positing that nominal income adjusts *before* such an increased supply of money could happen.

To complete the picture – how does the banking system create money? It first needed to extend credit to borrowers, and that activity would come down because the propensity of bear speculators to hold on to cash balances would spike long tenor interest rates. This would cause the supply of endogenous money creation to slow down and be inadequate for the cash-demanders. This self-reinforcing mechanism would propagate until nominal income adjusted down, finding the system a new, albeit sub-optimal stationary state.

In the GT Keynes went at this mechanism by going for the I=S identity, which led his critics to fume with the whole accounting identity vs behavioural relationship bit, but I am quite convinced from the GT that the above is the mechanism that Keynes was going for.

Further, I find it a bit disconcerting that Laidler posits the Hawtreyan mechanism as being about entrepreneurial pessimism and the Keynesian mechanism about speculators. A fall in Keynesian MEC is precisely about entrepreneurial pessimism and Hawtrey’s focus and obsession with the short rate and trade financing linked to it suggests that Keynesian theories should be more about capital markets vs Hawtreyan theories, which are more money market /banking dependent.

Laidler achieves this by interpreting the credit deadlock to be consistent with negative real rates of interest, while the fact is that in both Japan in the 90s and US/others today, real long tenor/ pvt borrowing rates were never negative! Only the real *short rate* was/is negative.

Ultimately, this goes back to how quickly one sees long tenor rates adjusting. Keynes does not see them as adjusting very soon, so his drop in entrepreneurial pessimism only crashes the *background* rate with the market rate not moving by much, while the Laidler/Hawtrey mechanism crashes the market rate while also leading to reduced quantity demand.

So, all in all, it is very tough to say that the Japan experience discredits Keynesian liquidity trap theories. It discredits a specific type of New Keynesian theory, which is Keynesian liquidity trap + Woodford-ian financial equilibrium, so that the entire term structure is fully represented by the short rate. But that should not be used to adjudicate credit deadlock vs liquidity trap as debated by Keynes and Hawtrey in the 20s and 30s.

Lastly, though Keynes did not do so, we can see several mechanisms through which his bear speculator theory works.

For one, the term premium is not the only premium – the credit risk premium is obviously the more pertinent one. Hawtrey/Laidler do not use this though they speak of a credit deadlock – would you categorize a spike in the credit premium as a ‘Keynesian’ mechanism or a Hawtreyan mechanism? I’d go with Keynesian.

Secondly, Keynes summarily dismissed the possibility of corporate saving. In his model, entrepreneurs were not engaged in saving or dis-saving. But these days, when corporations are such big net savers, it is possible to see that the bear-speculation of Keynes is being done BY the ‘entrepreneur’. This hastens the process of the downward adjustment of nominal income, because the financial system has been short-circuited.

For Keynes a drop in animal spirits would cause a fall in MEC and the level of I. An increase in the money supply would lower interest rates and increase I but if animal spirits are really depressed even with interest rates at zero I will be insufficient for full employment. This ZLB condition seems similar to Hawtrey’s ” credit deadlock”.

Keynes appears to think that the liquidity trap is something that may occur on the way to the ZLB . As the money supply increases at some point before interest rates hit zero people will prefer to hold the additional money in cash balances and not lend to banks – so increasing the money supply stops working.

Against the liquidity trap is the idea of a wealth effect. As people’s cash balances increase at some point they will start spending which (hopefully) will change business expectations (increase animal spirits) and boost I and get the economy out of the ZLB/liquidity trap. I’m wondering if Hawtrey’s disagreement with Keynes was about wealth effect v liquidity trap rather than the ZLB itself ?

This seems consistent with your statement that: “Quantitative easing worked not through a reduction of interest rates, but through the portfolio effects of increasing the quantity of cash balances in the economy, causing an increase in spending as a way of reducing unwanted cash balances”.

In both Japan and the US there is evidence that QE did indeed work via the wealth effect – but the aims of the CB in using QE were limited in both countries which means they stopped short of maximizing its potential to change business expectations.

The standard monetarist analysis assumes that the central bank can’t independently determine the price level and the money base. That’s true if money pays a lower rate of interest than short term bonds (positive seignorage). The demand for money is limited to medium of exchange demand.

At the zero bound, seignorage can go negative (if the central bank doesn’t mind losses), which expands the market for base money to non-MOE uses. A large increase in base money is consistent with price stability. This situation isn’t well described as a shortage of money, given that money is actually being issued at a loss. It’s a money glut, and the solution to a money glut doesn’t lie in producing more money.

“Quantitative easing worked not through a reduction of interest rates, but through the portfolio effects of increasing the quantity of cash balances in the economy, causing an increase in spending as a way of reducing unwanted cash balances.”

It can’t work like this. Unwanted cash balances are not spent but converted to deposits. From there, banks choose to keep the reserves as reserves balances in the Fed spreadsheet, so they truck the cash back to the Fed. The Fed cannot force the private sector to hold more cash than it wants.

I think that what you (Hawtrey and the two Davids) call “a credit deadlock” is very similar to what I call “an upward-sloping IS curve” (as an interpretation of Scott). Because income is low, and is expected to remain low (your “extreme entrepreneurial pessimism”), the rate of interest at which desired investment equals desired saving is itself low. So the IS curve slopes up (an increase in actual and expected future income/expenditure would raise the rate of interest at which I=S).

David,
Excellent piece. However, it raises several questions. First, I go back to the divergence between “entrepreneurial pessimism” and risk asset prices. As real rates fell, risk assets had one of the strongest rallies on record. These two are hard to reconcile. Second, if Japan had “credit deadlock”, why were its real rates positive while ours are negative? Clearly, the link between real rates and “pessimism” is quite weak.

As for the IOR, it was reduced to zero in the EU last year with little apparent consequence (i.e. lending continues to contract). Further, our IOR fell from 25bp to an effective rate of around 14bp after the FDIC adjusted its premium levy to include excess reserves in 2011: again, with little apparent consequence. Without the IOR explanation, the “monetary base” lacks any kind of explanatory power for credit explansion (or lack thereof).

Ironically, “entrepreneurial pessimism” in the US is merely a consequence of the changed consumption habits once it became clear (credit bust, housing bust) that no amount of credit could paper over the lifestyle changes necessary to make room for 2 billion more people deciding to engage in the globalized labor market (with sufficient technology making that easy/cheap to work across continents).

It’s a developed world income trap…..not a liqudity trap, nor a credit deadlock. Monetary policy is not going to fix this income trap, so this
is like shouting coaching advice at a televised sports event.

Blue Aurora, It’s also my impression that it was Dennis Robertson who coined the phrase liquidity trap. Sorry, I think I missed your emails. I will try to look for them. My papers are inching along not quite as rapidly as I hoped. Thanks for the link to the paper. It looks very interesting. I will have to reserve comment until I have had a chance to study it.

Ritwik, Thanks.

About the response of the banking system to an increase in the demand for money by bear speculators, I actually think that this was one respect in which Keynes’s analysis degenerated in going from the Treatise to the General Theory. The Treatise was full of analysis of how banks operate and respond to the public’s demand for money. In the General Theory, the supply of money is treated as an exogenously determined (by the monetary authority) fixed amount. That’s why he can simply posit that income effects precede money supply effects. That, at any rate, is my view, and I first encountered it in G. L. S. Shackles’ wonderful book, Years of High Theory. And Shackle of course was a great, but not uncritical, admirer of Keynes.

On what do you base your assertion that the real long rate has always been positive? The breakeven TIPS spread for 10-year Treasuries is now about -.60, and has been consistently negative for a couple of years.

However, I do agree with you to the extent that at very low nominal rates, the borrowing lending spread for banks may make it unprofitable for banks to supply as much cash as the public demands. However, the huge increase in the monetary base may have alleviated this problem. But I have not fully thought this through. Thanks for raising this explicitly; I will have to give it some further thought.

Rob, As a matter of terminology, I am not sure I agree with your reference to the wealth effect. It is not necessarily that people feel wealthier just that they want to readjust their portfolios and shift from cash into other assets including consumer durables.

Why is seignorage negative if the government (through the central bank) exchanges base money for its own long-term bonds and the interest rate on base money is less than the yield on the long-term bonds that it retires?

I agree that at the ZLB, the problem is not a shortage or excess demand for money.

PeterP, When the Fed pays interest on reserves, banks have an infinite demand for reserves, so no reserves are being held unwillingly. Currency is non-interest bearing, so it is possible that by issuing currency the public will spend some of the excess balances rather than just holding them or converting them to deposits.

Nick, Glad to have provided some mental stimulation. I agree with your idea of an upward sloping IS curve, which is also an implication of Earl Thompson’s reformulation of macroeconomic theory which I have been writing about from time to time.

Diego, Thanks.

I am not sure about risk asset prices. About positive real rates in Japan, at least for part of that period, positive real rates may have reflected monetary tightness. IOR doesn’t explain everything. The Fed wasn’t paying interest on reserves in the Great Depression. But having said that, I admit that the factual picture is not totally clear. Nevertheless, Hawtrey himself conceded that in a credit deadlock, it is possible that open market operations will not work and that a combination of fiscal and monetary expansion is required.

KnotRP, The trend that you have been describing has been going on for quite some time, I am not convinced that you have identified a sudden change in the perception of reality that required a massive readjustment of consumption and spending habits.

“Why is seignorage negative if the government (through the central bank) exchanges base money for its own long-term bonds and the interest rate on base money is less than the yield on the long-term bonds that it retires?”

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.